Mutual Fund Risk Types 2022: Types of Risks In Mutual Funds Investment
What is risk?
In simple terms, risk is an unexpected outcome. For example, you invest in shares, gold, or real estate with the expectation of prices going up after you buy so that you can earn a profit whenever you sell it. But, what if the price falls after you buy? After you purchase, the share, gold, or real estate price moving in the opposite direction (down) "than expected (up) is known as risk. Understand what does "mutual fund investments are subject to market risks" mean and everything you need to know about it.
Bank deposits are less riskier than mutual funds
When you invest in a bank fixed deposit, the bank promises you a fixed rate of return in writing. So, here there is no risk of earning a lower return than promised. But, if you invest in a debt mutual fund, the returns are not guaranteed as in the case of a bank fixed deposit. When the bank lends your money to a borrower in the form of a loan, the responsibility of recovering it lies with the bank. So, even if the borrower defaults, the bank will still give you back your deposit money on maturity.
On the other hand, when a mutual fund invests in debt security and the borrower company defaults, it will affect your returns. In the worst-case scenario, if the bank collapses, your deposits of up to Rs. 5,00,000 are insured by the Deposit Insurance and Credit Guarantee Corporation (DICGC) and any incremental money above Rs. 5,00,000 in the same bank will be lost. However, in the case of mutual fund investments, there is no such insurance. Hence, while bank deposits are not subject to market risks, mutual funds are subject to market risks.
Why is Mutual Fund Investment Risky?
Mutual funds are risky because they invest in a wide range of financial products, including equities, debt, corporate bonds, government securities, and so on. Because of a variety of variables, the price of these instruments fluctuates, potentially resulting in losses. As a result, determining the risk profile and investing in the most appropriate fund is critical.
A person's Net Asset Value decreases as a result of price fluctuation or volatility, resulting in a loss. In layman's terms, NAV is the market value per unit of all the schemes in which a person has invested after subtracting liabilities. As a result, determining the risk profile and investing in the most appropriate fund becomes critical.
How to Measure Mutual Fund Risk?
There are five basic investment risk indicators that can be used to analyze stock, bond, and mutual fund portfolios. They are the Sharpe ratio, alpha, beta, r-squared, standard deviation, and alpha. These statistical indicators are all essential components of modern portfolio theory and are historical predictors of investment risk/volatility (MPT).
Alpha is a risk-adjusted indicator of an investment's performance. It compares a security or fund portfolio's risk-adjusted performance to a benchmark index based on its volatility (price risk). The alpha of an investment is its excess return over the benchmark index's return.
Beta, often known as the beta coefficient, is a measure of a security's or a portfolio's volatility, or systematic risk, as compared to the market as a whole. The tendency of an investment's return to respond to market changes is represented by beta, computed using regression analysis.
The R-Squared is a metric that measures a fund's correlation to its benchmark performance on a scale of one to one hundred. If the R-Squared is 100, it means that the Mutual Fund's performance is perfectly associated with the benchmark's performance.
In finance, the standard deviation is used to calculate the volatility of an investment's yearly rate of return (risk). A stock with a high standard deviation is one that is highly volatile. The standard deviation of a mutual fund's return shows us how far it deviates from the predicted returns based on its past performance.
The Sharpe ratio is a risk-adjusted performance measurement. It's computed by subtracting the risk-free rate of return (US Treasury Bond) from an investment's rate of return and dividing the result by the investment's standard deviation of return.
Market risks and their types
Generally, the two broad categories of risks are market risks and company-specific risks. Market risks are those risks that affect the entire market overall. These risks are also known as systematic risks, as they affect the entire system overall. Some of the market risks include:
- Political instability: Political instability is a big risk for any market. If the Central Government is not stable then it affects the markets negatively. During the UPA II Government (2009-2014) there was economic policy paralysis in some years. Stagnancy of reforms led to a slowdown in GDP growth and a fall in the markets. Hence, the Government’s stability, reform agenda, and drive are important for the market to do well or be stable.
- Interest rate risk: High interest rates are not good for markets. We all saw how the high interest rates in the US-led to the sub-prime market crisis in 2008 which led to a big fall in stock markets all across the globe including India. During the peak of the crisis, Sensex and Nifty fell by more than 50% from their highs. Stock markets usually do well in a low-interest rate regime. Companies can borrow at lower interest rates and invest in business expansion leading to higher profits. When a lot of companies do well, markets overall do well.
- Inflation risk: India suffered from high inflation in 2010-13. In 2011, higher inflation was driven by higher crude oil prices which had crossed more than USD 100/barrel. Due to this, the RBI had to hike interest rates due to which the Sensex fell by around 25% in 2011. Stock markets usually do well when inflation is benign or moderate.
(Source: Dalal Street Investment Journal)
As can be seen from the above image, the Sensex does well when the crude oil prices are low and the Sensex underperforms when crude prices are high. Hence, high crude oil prices are a risk to markets.
- Currency risk: A currency that depreciates too much too soon, is a risk for the markets as it can lead to panic among investors and thus a sell-off in the overall market. The currencies of some Asian economies plunged in 1997 leading to the Asian Financial Crisis which resulted in a big sell-off in stock markets.
As seen in the above graph, the currencies of some Asian economies saw a big plunge in 1997-98. The fall in currencies leads to a big fall in the stock markets of these economies. A stable currency or a steadily appreciating currency is favorable for stock markets.
- Foreign fund outflows: The capital markets in India and many other economies are dependent on foreign fund inflows. Any reversal of foreign fund flows out of these economies is a big risk to capital markets and can cause a big correction in the markets. In 2007, SEBI imposed restrictions on investments in the capital market through participatory notes (P-notes) used by Foreign Institutional Investors (FIIs). This led to a big sell-off of Indian equities by FIIs leading to the Sensex and Nifty hitting a lower circuit breaker.
- High commodity prices: High prices of commodities like crude oil, gold, copper, aluminum, etc. are a big risk to individual and corporate consumers of these commodities. India imports most of these commodities. High prices of imported commodities, specifically crude oil and gold, put pressure on India’s current account deficit, fiscal deficit, foreign debt, etc. thereby destabilizing India’s balance of payments. This affects capital markets negatively. In 2008, most commodities prices reached record high levels, leading to high inflation and high interest rates. All this eventually led to capital markets collapsing.
- Default risk: Debt mutual funds schemes are exposed to the default risk of the borrower company not repaying the money borrowed against the issue of debt security. Debt schemes that invested in the securities of IL&FS in 2018 and DHFL in 2019 had to face losses due to default in repayment by these companies.
- Reinvestment risk: Debt mutual fund schemes face the risk of a fall in interest rates. If the interest rates fall from say, for example, 8% to 6% over a period of time, then the securities bought at higher interest rates of 8%, on maturity, will have to be reinvested at lower interest rates of 6%.
- Liquidity risk: Liquidity risk arises when a mutual fund scheme is not able to find a buyer for selling some of its portfolio securities or is able to find a buyer but at a lower price than the market/fair value. If some of the portfolio securities become illiquid, then the scheme may have to take a haircut to offload them, leading to losses for its investors.
- Company-specific risks: If a mutual fund scheme invests a big portion of its money in a specific company and if it does not do well, the returns of the entire portfolio will be affected. A company's share price may fall due to reasons like unsustainable debt, acquisition/s going wrong, fall in sales and/or profitability, unearthing of a scam, change in Government policy, loss of big clients, etc. In August 2018, the Yes Bank share was trading at around Rs. 400 during its peak. In one month, by September 2018, the share price fell by more than 50% to below Rs. 200. The returns of mutual fund schemes that had exposure to Yes Bank shares suffered.
Other Risks in Mutual Funds and Suitable Solutions
This section gives out light on some of the other common types of risks and its suitable solutions that an investor might face while investing in mutual funds.
|Volatility Risk||Market volatility can be mitigated by investing in a diverse portfolio of low- to moderate-risk funds.|
|Credit Risk||Invest in securities with a good credit rating and a history of paying out considerable and timely interest.|
|Liquidity Risk||Investing in a diverse portfolio that includes funds with moderate to high liquidity, such as liquidity funds, might be beneficial.|
|Concentrated Risk||Rather than investing in a single asset class or investment area, investors can spread their funds over multiple asset classes and sectors.|
|Inflation Risk||Investing in equity mutual funds, which offer higher risk-adjusted returns, can assist fight inflationary effects.|
How to address Mutual fund investment risks
As an investor, now you are aware of how your mutual fund investments are subject to overall market risks and company-specific risks. You can take the following steps to address these risks:
- Asset allocation: Depending on your age, risk profile, and other factors, you should follow an asset allocation strategy for your investments. When you distribute your money among different asset classes such as equity, debt, real estate, commodities, etc. your investment portfolio will be balanced. Different asset classes don’t have a perfect correlation with each other and don’t move in one direction. Hence, when one asset class is not doing well, the other may do well, thus safeguarding your portfolio.
Diversification: Once you decide on your asset allocation, within each asset class, you should diversify your investments. Diversification protects you from concentration risk. While investing in equities, you should spread your money across multiple companies, so that even if some companies don’t do well, your portfolio is still well protected and continues to earn returns. Equity mutual funds automatically provide you this diversification benefit.
For example, when you invest in a Nifty Index Mutual Fund, you invest in a basket of India’s top 50 companies. Similarly, when you invest in a midcap fund that has a midcap index as a benchmark, your investment gets diversified into 50-100 stocks in varying proportions depending on the Fund Manager’s decision.
- Long-term investments: Over long periods, economic cycles of boom and bust play out and the next phase of economic growth is better than the last time. Between 19800 and 2020, we had a lot of financial crises like the dot-com bubble burst, terrorist attack on the World Trade Center, sub-prime crisis, European debt crisis, crude oil spike, demonetisation, Covid-19, etc. Yet, during this time, the Sensex went up from 1000 to more than 50,000. If you make regular investments through a systematic investment plan (SIP) for the long-term, the market risks will be evened out and you will make good returns.
Not investing in Mutual funds is the biggest risk
In this article, we have seen the various risks that capital markets are subject to. But, if you don’t invest in mutual funds because of these risks, then you will lose out on earning good returns in the long run.
Let us understand this with the help of an example. There are two investors (A and B). A is completely averse to taking any risk and hence invests Rs. 1,20,000 every year in a bank fixed deposit at 6% p.a. On the other hand, B is open to taking some risk and hence invests Rs. 1,20,000 every year in an equity mutual fund. Let us assume the mutual fund scheme delivers a return of 12% CAGR. Let us see how much will A and B earn over different investment tenures and what is the difference in their earnings.
|Investment tenure||Returns @ 6% p.a.||Returns @ 12% p.a.||Difference|
|5 years||₹ 7,17,038||₹ 8,53,823||₹ 1,36,784|
|10 years||₹ 16,76,597||₹ 23,58,550||₹ 6,81,953|
|15 years||₹ 29,60,703||₹ 50,10,394||₹ 20,49,690|
|20 years||₹ 46,79,127||₹ 96,83,848||₹ 50,04,721|
|25 years||₹ 69,78,766||₹ 1,79,20,072||₹ 1,09,41,306|
|30 years||₹ 1,00,56,201||₹ 3,24,35,113||₹ 2,23,78,911|
As we can see from the above table, over 5 years, the difference (Rs. 1.36 lakhs) between what A and B earn is not much. But, as the investment time horizon increases, the difference in earnings also increases and reaches more than Rs. 1 crore in 25 years and over Rs. 2.2 crores in 30 years.
Hence, not investing in mutual funds is the biggest risk of all. Even if mutual funds are subject to market risks, you can address these risks with appropriate asset allocation, proper diversification, and regular disciplined long-term investments.
Mutual fund investments are subject to risks
Mutual fund schemes, depending on their objectives, invest in various asset classes like equity, debt, or a combination of both. These asset classes, in turn, are subject to various market risks. As the mutual fund scheme invests your money into these asset classes that are subject to various market risks, hence your “mutual fund investments are subject to market risks”. The details of the risks that the mutual fund scheme is subject to are mentioned in the scheme offer document. Hence it is mentioned: “Read all scheme related documents carefully”. The scheme documents that mention the details of these risks include the Statement of Additional Information (SAI), Scheme Information Document (SID), etc.
To do your risk assessment and to start investing in mutual funds, download the Glide Invest App and get started now.
The Bottom Line
Mutual funds, like any other investment programme, are always exposed to these and other dangers. While we may not be able to totally avoid these risks or the circumstances that produce them, we might plan and invest our money in such a way that the risks are minimised and the profits are maximised. Reduce the risks by employing various investment techniques and continuing to invest.
Q1: Is it possible to lose money in mutual funds?
A1: If you're wondering if mutual funds might lose money, you should know that some mutual fund categories are more volatile than others. This means that, while they may provide excellent rewards, they also carry a larger risk. If you're not willing to take on the risk, look at the success of mutual funds in other categories.
Q2: What is a mutual fund with a very high risk?
A2: High-risk mutual funds are those that have a lot of potential and can give you a lot of money. These funds, on the other hand, are extremely volatile and come with a high level of risk. These high-risk mutual funds are known for paying out large dividends to investors.
Q3: What is the definition of a low-risk mutual fund?
A3: Little-risk mutual funds, as their name suggests, are investment solutions with low risk and a predictable return. Real estate, government bonds, and other types of investments are the most common... They do it by investing a significant portion of their total assets in debt instruments.
Q4: Is it risky to invest in mutual funds?
A4: If you're worried about mutual funds being a risky investment, don't be. They're entirely safe. Because the SEBI (Securities and Exchange Board of India) and the AMFI oversee and manage mutual funds, no one can steal your money (Association of Mutual Funds in India).
Q5: Is it true that mutual funds are riskier than stocks?A5: Because mutual funds are diversified, they are less hazardous than individual equities. Diversifying your investments is an important strategy for risk-averse investors. Limiting your risk, on the other hand, may restrict the rewards you'll get from your investment.